Bringing the co-op advantage to new service areas.
As to the first question, KIUC has exceeded even the most optimistic expectations and is ahead of schedule on every financial metric. More than $10 million has been returned in rate rebates or patronage capital in just three years. The KIUC Equity Management Plan projects total patronage capital and rate rebates of more than $70 million in the first 10 years. Margins in 2004 totaled almost $13 million. Free cash flow after debt service has exceeded $32 million, and equity is now at eight percent, up from zero as of the closing, and on pace to reach almost 30 percent in l0 years. And it is of note that the cooperative's financial success has been achieved despite the continuation of rates in effect since 1995 with no base rate increases projected through 2013.
As to the second question, the KIUC transaction now looks like a model in a developing trend being replicated across the country--cooperatives are buying rural investor-owned (IOU) service territory, providing accelerated growth in cooperative membership for the 21st century. Since the KIUC transaction, Midwest Energy, Inc., in Hays, Kan., bought 10,500 customers from incumbent IOU Westar Energy; Vermont Electric Cooperative more than doubled in size by acquiring the adjacent IOU territory in northern Vermont; Rock County Electric Cooperative in Janesville, Wis., and Jo-Carroll Energy in Elizabeth, Ill., teamed to acquire all of the Illinois electric and natural gas customers of Alliant Energy through a competitive bidding process managed by Merrill Lynch & Co.; and Tri-County Electric Cooperative signed an agreement to acquire service territory in Oklahoma and Kansas from Southwestern Public Service (SPS), a subsidiary of Xcel Energy, Inc.
The stunning success of KIUC did not come easily, and lessons learned in the process were significant. Like all pioneers, KIUC's organizing board of directors has the scars to prove that being on the point will attract bullets and arrows. On the afternoon of August 14, 2000, the KIUC board learned via fax that the Hawaii Public Utilities Commission had denied their first attempt at the acquisition. It seemed that the dream of the first cooperative utility in Hawaii would never become reality. But some goals are just too worthy to abandon, and with the tenacity and dedication befitting his Marine Corp training, KIUC's chairman simply refused to allow the dream to die on the battlefield.
Victory--At Too High a Price
In July 1999, Citizens Communications headquartered in Connecticut--made the strategic decision to exit their regulated utility businesses and focus on telecommunications, a move prompting the sale of Kauai Electric on the Hawaiian Island of Kauai. Dedicated Kauai citizens quickly formed an Interim Organizing Board of Directors for the islands' first cooperative. The KIUC board, working under an extremely constrained timeframe, formulated an offer in the competitive bidding process. After several rounds of bidding, the good news was that KIUC won the bid! The bad news was the purchase price had escalated to almost $300 million all-in.
"In the first deal, the initial price we offered was not that far off from what we ended up paying with the second, successful transaction," said Gregg Gardiner, KIUC chairman. "But, we didn't have the expert negotiator with big deal experience on our side. We were out-gunned and out maneuvered throughout the process. We wanted so badly to control our energy destiny that we were afraid to let the deal go."
Indeed, the price became the focal point for community opposition and, ultimately, caused the PUC to turn the deal down because the financial projections showed no margin for error, likely prompting a rate case.
KIUC was challenged to reestablish its credibility and better prepare for another transaction. "Acquisitions involve professional skill sets that are not part of the toolbox we use to run our everyday business," Gardiner said. "As smart as we thought we were, we learned the hard way what we should have understood already--you don't go to your dentist if you need major surgery. There is a layer of sophistication that comes with multi-million dollar deals that adds a significant burden on the purchaser. You have to develop a sophisticated, professional team that can work together and build a plan that enables you to go toe-to-toe with the seller and say no when the deal isn't right."
For Gardiner and his board, their dream of local control led them to build a team and follow a disciplined five-step process:
1. The co-op acknowledged the price was too high and committed to negotiate a deal that the PUC would accept and would produce financial projections that met the financial fitness test required for approval.
2. KIUC reorganized its board, inviting key players to join who had been opposed to the price but not to the concept of cooperative ownership.
3. KIUC made the unprecedented decision to share its financial analysis with Citizens--an extremely rare move in merger and acquisition transactions. Doing so demonstrated that the reduction in price ($85 million less than the original sale agreement) combined with the lower interest rate climate created financial projections that would meet the financial fitness test of the commission. KIUC directed the attention of both Citizens and the PUC to three key financial criteria:
* TIER (times interest earned ratio); projections indicated TIER would comfortably exceed minimum requirements to avoid a rate case in the foreseeable future.
* Equity build up ratio; analysis demonstrated that over time the cooperative would build equity, making for a financially stable utility.
* Free cash flow; projections indicated there would be positive cash flow to make debt service payments and invest in the system to maintain its reliability.
4. The cooperative recognized the importance of the political process and community support. More than 60 face-to-face individual presentations were made to educate the citizens of Kauai about the benefits of not-for-profit cooperative ownership. As a result of those efforts, more than 400 green-shirted supporters of KIUC attended a public meeting set by the PUC and made a compelling case that the second transaction should be approved.
5. KIUC revamped its team of advisors bringing in experts that had the experience and credibility to address what had been identified as deficiencies in the first deal--inadequate financial analysis of the cost to operate independent of Citizens, insufficient due diligence, a price that did not allow for any margin of error in financial performance, and an unacceptable sales and purchase agreement.
All politics are local.
While the five actions KIUC took were crucial, a sixth action, ultimately, was the key to the deal: Prepare to overcome local opposition. On Kauai the rural electric cooperative model seemed such an obvious solution--one that would allow the community to control its own energy future--that the variety and volume of opposition was a surprise. Elected officials, the press and much of the community were vocal, and effective, in their opposition. KIUC developed an extremely high, and unpopular, profile. The solution was a thorough communications plan:
* Print materials were developed that explained what a cooperative was and what people should understand about the transaction. Volunteers were deployed throughout Kaua'i who handed these materials out on the street.
* KIUC advocates hosted more than 60 one-on-one meetings with key decision makers and influencers.
* The co-op presented at a public meeting to which the entire community was invited.
* KIUC built a Web site that was updated with the most recent developments.
* Ads were purchased that featured frequently asked questions (FAQs).
* The grassroots organization, Kauai People Power, was formed and hosted community forums to educate the public. They collected thousands of signatures and hundreds wearing green "People Power" t-shirts packed the public hearing on the co-op.
In the end, the community support was absolutely essential to the success of the deal.
Convincing the Experts
Despite all the KIUC board did to rebuild credibility, work remained to convince the various stakeholders after the PUC's denial of the first deal. The Kauai County Council filed with the PUC as an intervenor and initially opposed the transaction, a move partially attributable to the Council's desire to condemn and own the utility assets as a municipal utility. The Department of the Navy's Pacific Missile Range Facility, also an intervenor, was the third largest customer of the utility. It intervened to protect its interests relative to the cost of buying electricity. These officials and the Consumer Advocate would be looking hard at a second deal.
KIUC was well prepared for the next round. The co-op had its team in place and was prepared to negotiate a price that worked for the seller--$2l5 million, a reduction of close to $85 million from the price bid in the first deal.
The informal technical meeting called for in the PUC approval process, along with information submitted on the record, built credibility with the Consumer Advocate and other experts that led to a negotiated settlement. All deficiencies were addressed and a detailed financial analysis demonstrated that the new numbers worked. The presentation was clear. The facts and projections easily refuted opposing arguments. The evening following the technical meeting, KIUC was invited back by the Consumer Advocate to negotiate a settlement that provided endorsement for the deal. The terms were later accepted by the PUC as a part of the approval order, and thus began KIUC's unprecedented run of success.
"For the Island of Kauai, this was a huge win," said Gardiner. "We stepped up and took control of our own destiny and the financial results have been nothing short of spectacular. Now we are in the position to start investing in renewable energy and relieve ourselves of the dependency we have on oil."
Signs of a Trend
KIUC's success and that of other cooperatives that have followed in its wake may, indeed, indicate a trend. In recent years investor-owned utilities have renewed their focus on increasing operating efficiencies and making money on their regulated assets. Some are now willing to consider divesting themselves of territory where low customer density creates inefficiencies or there are too few customers to justify the regulatory cost and management attention of staying in a particular territory.
This renewed focus on the profitability of core electric service operations is in response to the credit debacle that followed the previous decade when growth of unregulated businesses ruled the day. Diversification, especially in merchant generation, energy trading and foreign operations, caused IOU debt to balloon. When those investments soured or failed to deliver projected returns, a credit crunch ensued as rating agencies penalized companies for straying from their core utility business.
With both operating costs and fuel prices rising, IOUs face the need for costly rate cases, often the first they have filed in more than a decade. In preparation for these cases, it has become almost universally apparent that large urban load centers have historically subsidized rural customers through single rate tariffs that do not accurately reflect the actual cost of service. Much of that rural territory is returning a lower profit per invested dollar, requiring either a significant rate increase to make a reasonable return or a decision to sell the assets.
In order to pay down debt, better manage debt service costs, and maximize the return on core service territory, some IOUs are simply deciding to exit the rural customer base on which they will never earn a fair return on investment. In many cases, the cost of the rate case would exceed the sum of the rate increase over the first few years, making the decision to sell the territory much easier. For IOUs, the sea change has been in leaving behind the territorial mentality that growing customers is good, shrinking them is bad. For the first time in decades, IOUs are applying serious financial analysis to the relative profitability of different assets. They see that rural assets diminish their ability to achieve a desired rate of return on the core business.
Cooperatives--The Acquirer of Choice
In contrast to their IOU brethren, cooperatives have generally stayed close to their utility distribution roots and for those rated by agencies, investment-grade ratings are the norm with positive or stable outlooks. Since the mid-1980's, cooperatives have built significant equity and now have the financial resources for acquisition transactions. According to data published by the National Rural Utilities Cooperative Finance Corporation, (CFC), distribution cooperatives enjoy an average equity-to-asset ratio of 43 percent, putting them in a stronger position than many IOUs that hurt their balance sheets with unregulated investments. In addition, the price a cooperative can pay is directly determined by the interest rate environment. Today, in a low interest rate environment, it is easier to meet the seller's objective on price. What the cooperative saves in interest expense can be the leverage that gets the deal done.
The time appears to be right, and evidence of cooperative acquisition activity is growing. In the last three years, cooperatives have acquired almost 165,000 new members in deals valued at more than $375 million. Why do these transactions make so much sense? A few examples illustrate the answer.
"This is the beauty of how well these acquisitions work," said Kelly Enright, executive manager of Vermont Electric Co-op, Inc., (VEC), in Johnson, Vt. "Vermont is not a pass through state and when the power supply market went crazy, we had to absorb $4 million in unanticipated increases in power supply costs. Even so, with the efficiencies of putting two systems together and a tremendous financial model, we accommodated those increases and still delivered on the bottom line."
For Vermont Electric, geography was a decisive element. The combination of improved customer service and the operating efficiencies of more than doubling in size avoided the need to file a rate case in 2003 that would have been required if not for the acquisition. With the consolidation of the northern Vermont territory, "windshield time" was significantly reduced to a number of both the existing members' and the acquired customers' locations. Windshield time is a function of how far linemen have to travel and how many are available to respond and, thus impacts the duration of an outage. Several inexpensive interconnections between the systems promised significant savings in wheeling costs. And the operating efficiencies allowed for the reduction in line crews, all to be achieved through retirements and attrition.
"I came to Vermont Electric on the heels of its bankruptcy as part of the reorganization," said Enright. "We saw that costs were going up and in order to manage costs and provide better service to our members, we had to grow." VEC's acquisition of Citizens Communications Company's Vermont Electric Division was finalized in April 2004. It now serves more than 37,000 members in 90 towns throughout Vermont and in Massachusetts along the Vermont border.
When Midwest Energy, Inc., (MWE), acquired contiguous territory of 10,500 electric customers from Westar Energy, Inc., for $33 million in 2003, geography was the driving factor. The western Kansas cooperative's service territory adjoined or surrounded most of the territory acquired from Westar. When the Westar line crew responded to a call, they often passed two or three MWE trucks on the way. So MWE could have been there faster, and at a lower cost. Maximizing this geographic advantage enabled MWE to realize considerable synergies in operating and maintaining the territory. This acquisition and others have helped MWE achieve economies of scale that have kept electric delivery rate increases at less than one percent in 13 years.
In Illinois, the acquisition of Alliant Energy territory was all about operating efficiency. Jo-Carroll Energy and Rock County Electric Cooperative, like most other cooperatives, had approximately six members per line mile. The acquisition would provide loads with over 25 members per line mile. The cost of operating the acquired territory was less than 50 percent on a per customer basis than the cost of the existing territory, clearly an operational benefit. It was a time-consuming and expensive process, but the cooperatives were successful at negotiating a price that made sense for the transactions and promised financial benefits in the future.
Making the Numbers Work
How are cooperatives able to acquire rural territory, inherently more expensive to serve, and yet achieve a measure of financial success as a result of these transactions? The answer lies in several unique financial features of cooperatives. Imbedded in the IOU cost of service are three components that provide cooperatives a financial advantage, and every transaction is based on these numbers.
1. Cooperatives pay no federal income tax, so all the rates charged by an IOU must include a component to recover taxes, an average multiplier of 1.7 times. This tax premium is available to the acquiring cooperative to help meet debt service obligations and keep utility rates at current levels after the acquisition.
2. All IOU rates include an allowed rate of return on equity--an expected return by shareholders. Cooperatives have no return on equity component in their rates, so they can use that component of existing rates to assist in payment for the acquisition.
3. Finally, most IOUs have a legacy cost of debt that is higher than the cooperative's current cost, and that has been factored into rates. Cooperatives can leverage that differential interest cost to make their acquisition deals work.
The Hard Road to a Deal
It is the nature of people and organizations to be most comfortable with the familiar. For an IOU looking to divest itself of assets, that means other investor-owned utilities have the advantage as buyer. At the start of the process, an IOU in the hunt to buy other IOU territory has a credibility advantage over a cooperative. The IOU buyer and seller believe they know each other and understand who they are dealing with. IOUs do not automatically think of cooperatives as buyers. Vermont Electric Co-op's experience was typical. It wasn't until the co-op assembled an expert team that the IOU engaged in earnest.
"We had our first contact with Citizens Communications in 1998," said Enright of Vermont Electric Co-op. "They always talked to us but they didn't take us very seriously. Citizens was working on larger dispositions of its property, but VEC had its sights on the Vermont property because it was the right thing to do. VEC put its heart and soul into getting this acquisition and once we added an expert team to do that, we had the professional edge that carried the deal through."
A business deal is negotiated between a willing buyer and seller. Once a cooperative establishes its presence at the bargaining table and clearly defines the positive business outcomes served by an acquisition, it can negotiate a deal where the numbers work for both parties. These types of transactions, however, are not for the faint of heart. They are grueling, expensive propositions with no guarantee of success. They demand a dedicated focus from the board and management of the cooperative. But the rewards are worth it when, through a successful acquisition, the cooperative is able to execute a long-term competitive strategy to minimize the cost of service to existing members.
Ultimately, patience is the key to dealing with an IOU. On the scale of their normal business operations, these are small deals to them. Citizens had multiple deals underway at the same time that KIUC and Vermont Electric were progressing, and both cooperatives had to endure long periods of silence and leap into action at a moment's notice when Citizens' attention turned to them. Ironically, this is one of the cooperative industry's key advantages if used correctly. Cooperatives do not have multiple layers of management that sign off on every decision, and their boards can be integrally involved from the beginning. To be successful, cooperatives must be more nimble, more responsive, and ultimately better prepared than their IOU competitors. In most cases, cooperatives have the home court advantage if they are willing to spend the time to plan for and execute the right deal.
Bill Collet, Partner, Christenberry Collet & Co.
Bill Collet is a partner with Christenberry Collet & Co., Inc., a Midwest investment banking firm that specializes in mergers and acquisitions, corporate fund-raising and financial and strategic planning for corporate clients throughout the country and abroad. Since its founding in 1994, the firm has assisted clients with more than $3 billion in corporate finance transactions.
Figure 1 FINANCIAL PARAMETERS: A DEAL THAT WORKS Consolidated TIER 1.75-2.00 Consolidated DSC* 1.80-2.10 Equity Rebuild over 30% in 10 years Free Cash Flow 30%-40% of purchase price in 10 years * Debt service coverage ratio Figure 3 Key Financial Drivers in IOU Territory Acquisitions * IOU rates usually lower due to density, BUT! IOU Coop Impact Income Taxes YES NO 1.7 Revenue Multiplier Return on Equity YES NO 10-12% Allowed Return Legacy Cost of Debt 6.5-7.5% 5.5-6.5% Lower Cost of Capital IOU Coop Return of Equity 11.8% 6.0% Debt Cost Legacy Debt cost 7.8% 1.50 TIER Weighted Cost of Capital 9.0% 9.0% Cost of Capital Tax Impact 1.7 1.0 Tax Impact Pre-Tax Cost of Capital 15.3% 9.0% Pre-Tax Cost of Capital * Take 6.3% return on assets for benefit of current members
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|Date:||Sep 22, 2005|
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